FAQ on Annuity and Compounding

Q.How is savings different from investing?

It is important to understand that saving money and investing money are entirely different things. They have different purposes, and play different roles. Saving money is the process of putting cold, hard cash aside and parking it in extremely safe places. Above all savings mean maintaining cash reserves which makes it easy for you reach for them; available to grab, take hold of, and deploy immediately with minimal delay no matter what is happening around you.

Whereas when you invest money, you don’t keep the money with yourself but instead pool the money with some institutions. Investments are made in banks as FD’s, RD’s, mutual funds, bonds (corporate or government), equity, index funds etc. The money, or capital is used to generate a safe and acceptable rate of return over time, making you wealthier. The returns in the investments are subject to changes in the market. Investing money means suffering volatility in returns and over a period of time investments bring returns.

It is correctly said that spending depletes wealth, savings create wealth and investing grows it.

Q.How does money grow in investing?

In investing there is a concept of compounding. Albert Einstein called compounding as the “the eighth wonder of the world”. “He who understands it, earns it; he who doesn’t, pays it,”.

Compound interest is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest. In simple interest, interest is calculated only on the principal amount.

Suppose the amount invested is Rs.100000 @ 10% for 3 years. The Interest earned on the amount shall be same 10,000 every year. But when the same amount is invested, compound interest shall be 10,000 in 1st year, 11000 in next year and 12100 in the 3rd year.

The rate at which compound interest accrues depends on the frequency of compounding, such that the higher the number of compounding periods, the greater the compound interest. The interest-on-interest effect can generate increasingly positive returns based on the initial principal amount, it has sometimes been referred to as the “miracle of compound interest.”

In short, when you invest money, you invest the principal amount you earn interest. In compounding, the interest earned gets added to the principal and then you on the accumulated interest you earn interest

Q. What should be the frequency of compounding?

The interest can be compounded on any frequency schedule from daily to annually. The frequency schedules can be daily, monthly, half yearly and yearly. When calculating compound interest, the number of compounding periods makes a significant difference. The more the compounding frequency, the higher is the returns.

Q.Albert Einstein said about compounding, “He who understands it, earns it; he who doesn’t, pays it”. What does this mean?

While the magic of compounding is called the eighth wonder of the world or man’s greatest invention, compounding can also work against consumers who have loans that carry very high-interest rates, such as credit card debt. A credit card balance of Rs 20,000 carried at an interest rate of 20% compounded monthly would result in total compound interest of Rs 4,388 over one year or about Rs. 365 per month.

On the positive side, the magic of compounding can work to your advantage when it comes to your investments and can be a potent factor in wealth creation. Exponential growth from compounding interest is also important in mitigating wealth-eroding factors, like rises in the cost of living, inflation, and reduction of purchasing power.

Q. What is a defined benefit plan?

Defined benefit pensions and Social Security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow over their life time. Now what is an annuity must be a question in everyone’s mind.

Annuities are designed to be a reliable means of securing steady cash flow for an individual during their retirement years. Annuity can also be created to turn a substantial lump sum into steady cash flow, such as for winners of large cash settlements from a lawsuit or from winning the lottery.

An annuity is a contract between the annuitant and an insurance company, who promises to pay you a certain amount of money, on a periodic basis, for a specified period. The annuity provides a kind of retirement-income insurance: You contribute funds to the annuity in exchange for a guaranteed income stream later in life.

Q.What are types of annuity?

Annuities can be classified as fixed or variable annuity. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity do well. Variable annuities provide for less stable cash flows than a fixed annuity but allows the annuitant to reap benefits of strong returns for the fund’s investments.

In order to balance risk and the possibilities of return, some features can be added to annuity contracts so that they work as fixed-variable annuities.

Q How annuities work?

There are two primary ways annuities are constructed and used by investors: immediate annuities and deferred annuities.

With an immediate annuity, a lump sum amount is contributed to the annuity account and the annuitant immediately begins to receive regular payments, which can be a specified, fixed amount, or variable depending upon the choice of annuity package. The pay-out will not change for the rest of your life.

Immediate annuity is taken if there is a one-time payment of a large lump sum, such as lottery winnings or an inheritance.Immediate annuities convert a cash pool into a lifelong income stream, providing guaranteed monthly allowance for old age. Sometimes people close to retirement purchase these with some portion of their retirement savings to add to their guaranteed income in retirement.

Example would be selling the home and putting the entire amount in the annuity. Suppose we invest 50 Lakhs in immediate annuity expect to receive a fixed pay-out every month for 10 years.

Deferred annuities are structured to meet a different type of investor need—to accumulate capital over the working life to build a sizable income stream for retirement. The regular contributions made to the annuity account grow tax-sheltered until the income is drawn from the account. This period of regular contributions and tax-sheltered growth is called the accumulated phase. There can be a large lump sum contribution and it shall be followed by smaller contributions.

Q. How liquid are annuities? Can we withdraw money out of it when required?

Annuities are generally not liquid. Deposits into annuity contracts are typically locked up for a period of time, which is known as surrender period. If the amount locked in is withdrawn, the annuitant incurs a penalty. The surrender period or the lock in period varies from 2 to 10 years depending on the particular product.

Q. Who should buy annuities like defined benefit plans.

Individuals seeking stable, guaranteed retirement income should go for annuity. It serves as a means to enable those people to have certain cash flows because the lump sum put into the annuity is illiquid and subject to withdrawal penalties. It is not recommended for younger individuals or for those with liquidity needs to use this financial product.

Q. Is life insurance an example of Annuity?

Life insurance companies and investment companies are the two primary types of financial institutions offering annuity products. Life insurance is bought to deal with mortality risk – that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death. If the policyholder dies prematurely, the insurer will pay out the death benefit at a net loss to the company.

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